Patinkins Real Balance Effect

The homogeneity hypothesis states that the demand and supply of goods are pretentious
only by relative prices. It means that a doubling of money prices will have no effect
on the demand and supply of goods. Arithmetically the demand and supply functions for
goods are standardised of degree zero in prices alone.

Therefore this homogeneity hypothesis precludes the price level from affecting the goods
market as well as the money market. Patinkin criticises this hypothesis for its failure
to have any determinate thesis of money and prices.

Another closely related presumption which Patinkin criticises is the discrimination
of the goods and money in the neo-classical study. This dichotomisation means that
the relative price level is determined by the demand and supply of money.

Similar to the homogeneity hypothesis, this presumption also implies that the price
level has completely no effect on the monetary segment of the financial system and
the level of monetary prices in turn has no effect on the real segment of fiscal system.

After reproaching the neo-classical presumptions outlined above, Patinkin puts together
the money market and the goods market of the fiscal system which is based not only
on associative prices but also on actual balances. Actual balances mean the original
purchasing power of the stock of cash holdings of the people.

When the price level variations, it affects the purchasing power of people’s cash
holdings which in turn, affects the demand and supply of goods. This is the real balance
effect Patinkin denies the subsistence of the homogeneity hypothesis and the dichotomisation
presumption through this effect. For this Patinkin introduces the stock of real balances
(M/P) held by society as an authority on their demand for goods.

Therefore, the demand for a commodity diminishes the real balances of the people who
will spend less than before. This implies a fall in the demand for goods and the consequent
fall in prices and wages. The price decline increases the value of money balances held
by the people which in turn mount the demand for goods directly.

The initial decline in commodity demand creates a state of involuntary redundancy. But
redundancy will not last indefinitely for the reason that as wages and prices drop,
the actual balance effect is likely to hike commodity demand directly and indirectly
through the interest rate.

With sufficiently
large drop in wages drop in remuneration and prices the full employment level of productivity
and earnings will be restored. Finally, even if there is the employment level of productivity
can be restored through the function of the real balance effect – react on the
commodity markets and therefore on relative prices.

The real balance effect is represented diagrammatically by using the IS and LM
technique for the reason that the IS curve represents the goods market and the
LM curve the money market.

To start with we take a condition when the fiscal system in symmetry ay OY1 level
of earnings when the IS and LM curves interconnect at point A where the overlap
rate if Or1.

Presuming OYF as the full employment is measured by Y1 – YF which causes
wages and prices to drop simultaneously.

This results in a hike in the real value of people’s money holdings which
transfers the LM curve to the right to LM1. It overlaps the IS curve at point B
the earnings level OY2 with the result that the interest rate drops to Or0 which
inspires investment, discourages savings and enhances consumption.

Even when the interest rate drops to its minimum level Or0 the level of demand
in the commodity market as represented by the IS curve is not high enough to tend
the fiscal system to the full employment level OYF.

Rather, redundancy tends to a further drops in wages and prices and to the hike
in demand for consumption goods which transfers the IS curve to the right to IS1
so that it overlaps the LM1 curve at point C at the full employment level OYF.

Therefore, under stipulations of remuneration and price flexibility when the fiscal
system to the full employment level, even in the liquidity entrap condition as
represented above when investment is interest inelastic.

Conclusion

Therefore, the real balance effect reveals three theoretical points: first, it diminishes
the classical dichotomy among value and monetary theory, second it validates the conclusions
of the quantity thesis that in symmetry, money is neutral and the interest rate is
independent of the quantity of money through the real balance effect and third, the
wage price flexibility tends to full employment in the long run and that the Keynesian
underemployment symmetry is a dissymmetry condition.

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